Equity Valuation: Definition, Importance and Process

Throughout finance, one rule always holds true. The general belief is that the value of any asset or security is exactly equal to the discounted present value of all the cash flows that can be derived from it in future periods.

Using this principle, one can easily value securities like debt. This is because they have a finite existence. The cash flows derived from them can be easily predicted. However, equity valuation is not so simple. Equity represents a partnership in the business. As such, it represents an attempt to value cash flows which are uncertain and unpredictable.

In this article, we will try to understand the concept of equity valuation in more detail.

Definition

In finance, valuation is a process of determining the fair market value of an asset. Equity valuation therefore refers to the process of determining the fair market value of equity securities.

Importance of Equity Valuation: Systemic

The whole system of stock markets is based upon the idea of equity valuation. The stock markets have a wide variety of stocks on offer, whose perceived market value changed every minute because of the change in information that the market receives on a real time basis.

Equity valuation therefore is the backbone of the modern financial system. It enables companies with sound business models to command a premium in the market. On the other hand, it ensures that companies whose fundamentals are weak witness a drop in their valuation. The art and science of equity valuation therefore enables the modern economic system to efficiently allocate scare capital resources amongst various market participants.

Importance of Equity Valuation: Individual

As discussed, on a micro level, equity valuation is beneficial for the entire stock market ecosystem. However, how does it benefit an individual to study and apply the principles of equity valuation?

Well, markets receive information every moment and make an attempt to factor the financial effect of this information in the stock price. Individual estimates of the effect vary and as such different people may come up with different stock prices. Therefore, there can be a difference between the market value of a company and what investors call its true or “intrinsic value”

Investors, stand to gain a lot of money if they are able to correctly identify this difference. The second richest person in the world, Warren Buffett has made his fortune correcting and applying the art of equity valuation. In fact, the theory of equity valuation has been heavily influenced by the work of Warren Buffett and his mentor.

Process of Conducting Equity Valuation

Equity valuation is followed differently by different individuals. As such, there is no set pre-defined standard process. Instead, equity valuation consists of 4 or 5 broad categories of steps that need to be followed. The procedures maybe different but the objectives are always the same. Every person conducting equity valuation, must in one way or another account for these parameters:

1. Understand the macroeconomic factors and the industry: No company operates in vacuum. As such, the performance of every business is influenced by the performance of the economy in general as well as the industry in which it operates. As such, before making an attempt to value a business, the macro-economic factors must be accounted for. A reasonably accurate prediction regarding these parameters creates the base for an accurate valuation.

2. Make a reasonable forecast of the company’s performance: Mere extrapolation of the company’s current financial statements does not constitute a good forecast. A good forecast takes into account how the company may change its scale of production of the forthcoming future. Then, it also takes into account how changes in this scale will affect the costs. Costs and sales do not move in linear fashion. To come up with an accurate forecast, an analyst would require intricate knowledge of the company’s business.

3. Select the appropriate valuation model: Valuation is less of a science and more of an art. There are multiple valuation models available. Also, all these valuation models do not necessarily lead to the same conclusion. Hence, it is the job of the analyst to understand which model would be most appropriate given the type and quality of data available.

4. Arrive at a valuation figure based on the forecast: The next step is to apply the valuation model and come up with an exact numerical value which according to the analyst defines the worth of the business. It may be a single estimated amount or it could be a range. Investors prefer a range so that they clearly know what their lower and upper bounds for bidding should be.

5. Take action based on the arrived valuation: Finally, the analyst has to give a buy, sell or hold recommendation based on the current market price and what analysis shows is the intrinsic worth of the company.

The process of equity valuation is thus long, subjective and difficult to understand. However, for those who do master this art, the rewards are enormous.